Despite this lackluster
performance record as compared to the broad equities market, record
amounts of capital continue to ﬂow into the hedge fund industry.
In recent years, the private equity industry compensation vehicle of
carried interest (the proﬁt share paid to the manager for performance)
has also been the subject of much scrutiny. As a complex tax issue, carried interest has often been described as the primary means by which
asset managers—including both private equity managers and hedge
fund portfolio managers—rake in large amounts of compensation.27
Because carried interest and performance fees represent the majority
of the large sums earned by the top-performing independent asset
managers, the taxation of carried interest has become a controversial political issue. Currently in the United States, carried interest has
been deﬁned as a capital gain for individuals receiving these payments,
and as such it has been subject to materially lower capital gains tax
rates.

…

Currently in the United States, carried interest has
been deﬁned as a capital gain for individuals receiving these payments,
and as such it has been subject to materially lower capital gains tax
rates. Supporters of characterizing carried interest as a capital gain
argue that this policy encourages productive investment and economic
growth. Detractors point to relative tax burdens and the undermining
of a progressive taxation system. Whatever the relative merits of these
positions, it is indisputable that carried interest and its capital gains
treatment are certainly contributing to the rise and continued ﬁnancial
success of this new elite.
THE COMPENSATION STRUCTURE
AND ITS NUANCES
The Problem of Bundling Beta and Alpha
Performance fees are almost always paid on return, not alpha. Alpha is
the amount of risk-adjusted value, relative to the appropriate benchmark, that a manager has added through investment management
talent—that is, through some combination of security selection, timing, sizing investments, or risk management.

…

Third, there are incentive
arrangements that pay off to the stewards of capital when investors
Conclusion 327
earn a return. In public environments, these incentives are sometimes
structured as stock options for management teams to earn money
when the stock performs well. In private equity environments, these
incentives are structured as carried interest, a portion of the proﬁts of
the partnership that goes to the manager.
However, the future of investment must contemplate how some of
these arrangements can distort behavior. Might the carried-interest
feature cause certain stewards to treat it like a call option and invest
in circumstances that are “heads I win, tails you lose”? Might there be
opportunities for making corporate boards more shareholder friendly
and reducing some cases of corporate abuses? Certainly, activist investors to some degree are pursuing such enhanced governance structures, but there is work that remains to be done.

“The hedge fund guys didn’t build this country,” Trump said. “These are guys that shift paper around and they get lucky.”13
One smart line of investment that the hedge fund guys make every year is their contribution to members of Congress. The politicians, in turn, serve their funders by protecting the carried-interest preference from all challengers. Despite its unpopularity, this particular tax break has proven so hard to eliminate that Barack Obama sought to circumvent it instead: he proposed to keep the carried-interest provision but to add a new requirement—it’s been dubbed the Buffett Rule—that says anybody with adjusted gross income over $1 million must pay at least 30% of it in income tax. It was this presidential initiative that prompted the financier Stephen Schwarzman to evoke the Nazis: “It’s like when Hitler invaded Poland in 1939.”

…

Generally, we don’t get to see the benefits of the carried-interest preference for any specific taxpayer. But that changed, briefly, in 2012, when the Republican presidential nominee, Mitt Romney, was pressured into releasing a couple of his tax returns. In the year 2010, Ann and Mitt Romney reported adjusted gross income of $21.6 million; most of this was deferred salary paid by the investment firm from which Romney had retired twelve years earlier. The couple gave generously to charity—about $7 million—and reported capital losses on various transactions. This reduced their taxable income to $17.1 million. Had this income been reported as salary, they would have paid more than 35% of it in income tax. But under the tax code, almost all of the Romney income was deemed carried interest. Consequently, their tax rate fell to 13.9%—a lower rate than taxpayers earning less than 1% of their income.

…

To add to the candidate’s embarrassment, the return showed that Romney held some of his money in the Cayman Islands, a famous haven for people trying to hide money from the tax authorities. Romney conceded that he had accounts in the Cayman Islands but said this was not for tax purposes. To which the attorney Frank Schuchat responded, “To say you put money in the Caymans, but not for tax purposes, is like saying you bought a condom, but not for sex.”
The carried-interest tax break is one of those things that make the United States exceptional when it comes to tax policy. “Most other countries would never think of a dodge like ‘carried interest,’” notes the tax expert Richard Bird. “It’s proof—as if any more proof were needed—that big money gets its way in the U.S. Congress.” And this mammoth tax gift to the richest Americans is one of the reasons that the problem of inequality is so much “more pronounced” in the United States than in other developed democracies.

pages: 253words: 65,834

Mastering the VC Game: A Venture Capital Insider Reveals How to Get From Start-Up to IPO on Your Terms
by
Jeffrey Bussgang

But the potential for really big money lies in the “carried interest,” that is, the percentage of profits—usually in the 20 to 25 percent range—that a VC fund earns if their fund performs well.
So what’s the VC business model? Raise a fund, get paid 2 to 2.5 percent annually in fees to manage that fund, cover salaries and expenses, and make investments that you hope will generate large capital gains. When those returns are actually generated (e.g., because the portfolio company has a successful sale or IPO), the VC funds typically get their carried interest in the capital gains.
Let’s walk through a typical example to see how carry is calculated. Let’s say there’s a $150 million fund with three general partners with 2 percent in annual fees and 20 percent in carried interest. The firm takes in $3 million in annual revenue and after paying for rent, support staff, associates, travel, et cetera, the three partners might take $400,000 to $500,000 each in salary.

…

The firm takes in $3 million in annual revenue and after paying for rent, support staff, associates, travel, et cetera, the three partners might take $400,000 to $500,000 each in salary. If the fund returns two times the capital, or $300 million, over the ten-year life of the fund, then $150 million is considered capital gains. The VCs get 20 percent of that amount, or $30 million in carry, to be divided up between the partners according to who has how much of the carried interest (a very sensitive division, the implications of which I’ll cover in a moment). If the fund doesn’t generate any capital gains, the VCs get nothing beyond their salaries paid out of the annual revenue. Because VC funds are treated as separate economic entities, once the VCs have finished investing in a particular fund, they need to raise another one from their limited partners.
Funds do have long shelf lives—typically ten years—because the companies they invest in usually do not achieve liquidity for five to seven years.

…

Thus, both fee income and carry opportunity from multiple funds are gradually harvested year by year.
Note that associates and principals don’t typically have carry. Junior partners with small slivers of carry (perhaps having one or two of the twenty “carry points”) are usually supervised by senior partners who closely oversee the diligence and decision-making process. If the partners themselves are not on an equal footing in terms of carried interest, an individual partner may not be able to “speak for the firm” when it’s time to make tough decisions about follow-on rounds and M&A transactions. Even the most senior partners within a firm still need to get to consensus across the partnership. That said, when your “deal champion” (i.e., the investment professional that is advocating your case within the partnership) is a subordinate within the VC firm, it can be a harder and longer process than when the deal champion is one of the senior partners.

Off and on over the previous year, various senators and congressmen had brought up the idea of altering the treatment of carried interest for private equity and hedge fund managers. The press was filled with stories of hedge fund gurus who made more than $1 billion in 2006, and Fortress had revealed during its IPO that its three founders, Wesley Edens, Peter Briger Jr., and Michael Novogratz, and two other senior managers had received $1.7 billion from their firm shortly before Fortress’s IPO.
The capital gains advantage was not unique to private equity or hedge funds. It stemmed from general principles of tax and partnership law and the gaping differential between the tax rates on ordinary income and capital gains. Carried interest by definition consists of investment profits, which are capital gains for tax purposes, and partnership law allows profits to be allocated to different classes of partners as the partnership chooses.

…

(The investors, who become limited partners in a partnership, don’t write a check for their full commitment at the outset; they merely promise to deliver their money whenever the general partner issues a demand, known as a capital call, when it needs money for a new investment. Even so, the general partner collects the full 1.5 percent from the limited partners every year no matter how much of the money has been put to work. When the funds themselves begin to wind down after five or six years, the management fee is substantially reduced.)
Richer yet was the potential bonanza Blackstone stood to make in “carried interest.” By the conventions of the business, private equity firms take 20 percent of any gains on the investments when they are sold. If Blackstone raised the hoped-for $1 billion and the fund averaged $250 million in profits a year (a 25 percent return) for five years running—a not impossible mark—Blackstone would be entitled to $50 million a year, or $250 million over five years.
On top of that, the companies Blackstone bought would reimburse Blackstone for the costs it ran up analyzing them before it invested and for its banking and legal fees.

…

Its companies would also pay advisory fees to Blackstone for the privilege of being owned by it.
A more lucrative compensation scheme was hard to imagine. The fee structure ensured that if the fund was big enough, the financiers would become millionaires even if they never made a dime for their investors. The management fees alone guaranteed that with a large fund. If they made good investments and collected their 20 percent carried interest, they stood to make a lot more. While the individual partners at a successful midsized firm such as Gibbons, Green, or van Amerongen might earn $2 million in a good year, the industry’s kingpins, Henry Kravis and George Roberts, overseeing multibillion-dollar funds, each took home upward of $25 million in 1985. This was several times more than what the CEOs of Wall Street’s most prestigious investment banks made at the time, and it dwarfed what Peterson had earned as CEO of Lehman.

Bloomberg is, of course, himself both a plutocrat and one of the country’s most prominent financial entrepreneurs. As New York’s mayor, he has defended Wall Street with the hometown zeal of a Detroit politician supporting the carmakers or a prairie leader backing farmers.
Nonetheless, here was Bloomberg on carried interest: “Since fair is fair, tax loopholes in the financial industry that are outdated should be closed, too, such as taxing carried interest at ordinary income rates. And I say this even though many of the people who would be affected are my constituents—so I assume I will get some phone calls later this afternoon.”
GALT’S GULCH
Carried interest is a very specific issue that touches a very specific group of people. The rise of Occupy Wall Street has brought a broader critique of the 1 percent to the fore, and in doing so has spurred some of the plutocrats to mount a more general self-defense.

…

Two other former Obama backers on Wall Street—both claim to have been on Rahm Emanuel’s speed dial list—recently told me that the president is “antibusiness”; one went so far as to worry that Obama is “a socialist.”
In some cases, this sense of siege is almost literal. In the summer of 2010, for example, Blackstone’s Schwarzman caused an uproar when he said an Obama proposal to raise taxes on private equity firm compensation—by treating carried interest as ordinary income—was “like when Hitler invaded Poland in 1939.”
However histrionic his metaphors, Schwarzman (who later apologized for the remark) is a Republican, so his antipathy for the current administration is no surprise. What is perhaps more surprising is the degree to which even former Obama supporters in the financial industry have turned against the president and his party. A private equity manager who is a passionate Democrat and served in the Clinton administration proudly recounted to me his bitter exchange with a Democratic leader in Congress, who was involved in the tax reform effort.

…

A private equity manager who is a passionate Democrat and served in the Clinton administration proudly recounted to me his bitter exchange with a Democratic leader in Congress, who was involved in the tax reform effort. “Screw you,” he told the lawmaker. “Even if you change the legislation the government won’t get a single penny more from me in taxes. I’ll put my money into my foundation and spend it on good causes. My money isn’t going to be wasted in your deficit sinkhole.”
Indeed, within the private equity fraternity, which would be hardest hit by a change in the tax treatment of carried interest, this is very much the majority view. When I met him in his boathouse on Martha’s Vineyard, the cofounder of a private equity firm warned that raising the taxes on his industry would “kill” investment in this country and drive the money overseas. He also said it was morally unjust because private equity professionals like himself put their own money at risk and so did not deserve to have their profits taxed like regular income.

A year later,
hedge fund manager John Paulson earned some $4 billion.
These managers also enjoy remarkably favorable tax treatment, for reasons that no one can seem to explain with a straight face. For example, even
though “carried interest”—mainly their 20 percent commission on portfolio
gains—has the look and feel of ordinary income, it’s taxed at the 15 percent
capital gains rate rather than the 35 percent top rate for ordinary income.
That provision alone saved Mr. Paulson some $800 million dollars in taxes
in 2007.
Congress periodically considers proposals to tax carried interest as ordinary income. To no one’s surprise, financial industry lobbyists are always
quick to insist that doing so would kill the geese that lay the golden eggs. The
deals brokered by their clients often create enormous value, to be sure.

…

The
deals brokered by their clients often create enormous value, to be sure. Yet
the proposed legislation would not block a single transaction worth doing.
The same deal that currently augments a hedge fund manager’s after-tax
income by $1 million would augment it by $765,000 if carried interest were
taxed as ordinary income. Can anyone credibly claim that this would make
him abandon the deal?
Economic analysis suggests that higher taxes on hedge fund managers
would actually boost production in other sectors of the economy by alleviating wasteful overcrowding in the market for aspiring portfolio managers.
This market is a prime example of a winner-take-all market—essentially a
tournament in which a handful of winners are selected from a much larger
field of initial contestants. Such markets tend to attract too many contestants
for two reasons.
One is an information bias.

So if the limited partners have committed $100 million in capital,
payouts from the investments must rise above $100 million before the general partners begin to receive carried interest. Thereafter, the GPs will be
paid 20 percent of any returns. So if the fund eventually closes out with
$200 million in exit proceeds, the GPs will earn $20 million (i.e., 20 percent of $200 million - $100 million). But some firms base their carry on the
difference between the exit proceeds and the investment capital rather than
committed capital. The investment capital is the committed capital less the
management fee, so this variation on the carry results in a larger payout to
the GPs.
To complicate matters, private equity funds often have hurdle rates
that must be earned by the limited partners before carried interest is paid
to the general partners. Metrick and Yasuda (2010) show that the most
common hurdle rate for both VC and buyout funds is 8 percent.

…

Cambridge Associates, an institutional investment consulting firm,
provides an index of returns net of fees as reported to the limited partners
that CA has as clients. Since CA has a large share of the institutional market,
its index covers upward of 80 percent of all VC funds in existence. The index
begins in 1981.
Metrick (2007, Chapter 3) provides an analysis of the biases in each
index. The returns on SHE are actually lower than those on CA despite the
fact that the latter nets out management fees and carried interest. He uses a
rough estimate of management fees and carried interest to adjust the SHE
returns to a net basis. This results in a 7.5 percent gap between the CA and
SHE indexes.6 Metrick argues that the CA index has survivorship bias due
to the fact that many VC firms attract institutional money only after they
have had successful VC funds. He suggests treating the CA index as an upper
bound for estimates of true VC returns.
All VC returns are plagued by stale pricing.

…

The limited partners agree to commit a certain amount
of capital, and the general partners draw down this amount as they invest
in enterprises. The drawdown period typically takes several years, so the
investors must keep the capital in liquid form in the meantime. Capital is
typically committed for 10 years with limited extensions at the discretion of
the general partners.
Fees generally take two forms, a management fee levied on the committed capital and an incentive fee (termed carried interest or carry) based
on performance. A typical fee structure involves a 2 percent management
fee and a 20 percent incentive fee. The 2 percent management fee is levied
on the committed capital from the beginning of the fund regardless of how
much has been drawn down. So if there is a $100 million fund with capital
committed for 10 years, then the total management fee will be $20 million
over the 10-year period ($2 million per year).2 The incentive fee kicks in
after the limited partners have recovered their committed capital.

As Chrystia Freeland writes in her book Plutocrats, the June 21, 2007, initial public offering of stock in Blackstone, his phenomenally successful private equity company, “marked the date when America’s plutocracy had its coming-out party.” By the end of the day, Schwarzman had made $677 million from selling shares, and he retained additional shares then valued at $7.8 billion.
Schwarzman’s stunning payday made a huge and not entirely favorable impression in Washington. Soon after, Democrats began criticizing the carried-interest tax loophole and other accounting gimmicks that helped financiers amass so much wealth. In the wake of the 2008 market crash, as Obama and the Democrats began talking increasingly about Wall Street reforms, financiers like Schwarzman, Cohen, and Singer who flocked to the Koch seminars had much to lose.
The hedge fund run by another of the Kochs’ major investors, Robert Mercer, an eccentric computer scientist who made a fortune using sophisticated mathematical algorithms to trade stocks, also seemed a possible government target.

…

He described McCarthy as a “serial offender” who had played “a pretty big part in lowering the bar on what is acceptable in American politics.”
—
Shortly before the Kochs held their second summit of the year, a June get-together at the St. Regis Resort in Aspen, they got a break that enormously increased their network’s financial clout when House Democrats passed a bill, backed by President Obama, to eliminate the so-called carried-interest loophole. The idea of eliminating the special tax break enjoyed by private equity and hedge fund managers struck fear in the finance industry. Obama had won the support of a surprisingly large share of New York’s finance titans in 2008, but his stance on the tax—which would never make it through the Senate—enraged many of its heaviest hitters. Stephen Schwarzman, the chairman and CEO of the enormously lucrative private equity firm the Blackstone Group, whose personal fortune Forbes then estimated at $6.5 billion, would call the administration’s efforts to close the loophole “a war,” claiming it was “like when Hitler invaded Poland in 1939.”

…

Financiers resented being blamed for the collapse of the economy in 2008, they took extreme umbrage when Obama had chastised them as “fat cats,” and they claimed that his administration was run by college professors who knew nothing about business. But Schwarzman and a number of other financiers regarded this as a new level of affront and flocked to the June Koch summit with their checkbooks in hand, determined to prevent his reelection.
Ironically, it was probably Schwarzman’s own excesses that had brought the carried-interest loophole to critics’ attention. In 2006, when he decided to transform Blackstone from a private partnership into a public company, he had been required to disclose his earnings for the first time. The numbers stunned both Wall Street and Washington. He made $398.3 million in 2006, which was nine times more than the CEO of Goldman Sachs. On top of this, his shares in Blackstone were valued at more than $7 billion.

In 2007, the top twenty-five hedge fund managers earned nearly $900 million on average.9 Despite their awe-inspiring incomes, some of these financiers have been able to exploit features of tax law that predate the rise of hedge funds to pay only a 15 percent federal tax rate. Yes, 15 percent. “Carried interest” provisions allow fund managers to treat some of the spectacular fees investors pay them as capital gains—a favorable treatment supposedly reserved for those who are putting their own investments at risk. Warren Buffett used to say that it was outrageous that he and his secretary paid the same tax rate. Those benefitting from the “carried interest” loophole can do him one better. They pay a dramatically lower rate than their secretaries.
As egregious as this loophole is, the defense game of Wall Street supporters like Schumer kept it firmly in place. Adopting the Scarlett O’Hara defense, he insisted that he supported reform but wanted to get it right—something that, hopefully, would happen tomorrow.

…

About the only area where audits have gone up is among poorer taxpayers who claim the Earned Income Tax Credit.12
Another way public officials have cut the taxes of upper-income filers without passing new laws is by leaving in place loopholes through which rich Americans and their accountants shovel lightly taxed cash. Take one of the more egregious examples: the ability of private equity and hedge fund managers to treat much of their extraordinary incomes as capital gains, subject only to a 15 percent tax rate. (In 2006, the top twenty-five hedge fund managers earned nearly $600 million on average, with the richest, James Simons, taking in $1.7 billion.)13 The “carried interest” provision that allows this sweetheart deal is a bug in the tax code that predates the rise of hedge funds. But while this loophole is almost universally viewed as indefensible (and may finally be closed a bit in 2010), it has been protected for years by the fierce lobbying of its deep-pocketed beneficiaries and the strong backing of Wall Street supporters like Senator Chuck Schumer, Democrat of New York.

If the process is unsuccessful, the equity will prove worthless and some of the lenders may take a hit.
The general partners (those who run the fund) will earn their cut in two ways. First, they will take an annual management fee, which may be as much as 2 per cent of the funds invested. This fee is designed to cover the managers’ running costs. Secondly, they will take a performance fee, known as ‘carried interest’, when the assets are sold, often 20 per cent of all profits after an agreed hurdle return has been reached. It is this carried interest that has made private equity fund managers rich. And it has also aroused plenty of controversy, given that it is taxed in many jurisdictions as a capital gain, rather than as income. Since capital gains usually bear a lower tax rate, this results in the anomalous situation where private equity managers are taxed at a lower rate than their office cleaners, as one financier memorably described it.

These incomes are lightly taxed due to the carried interest exemption, a tax loophole that taxes the income of hedge fund managers as capital gains instead of labor income, as shown dramatically by presidential candidate Mitt Romney’s tax returns. He paid taxes of less than 15 percent of his high income (which was smaller than the financial superstars’ incomes just described).24
The carried interest loophole is only one of the ways that members of the FTE sector reduce the taxes they pay. As congressional leaders were completing a massive tax and spending bill in late 2015, lobbyists descended from those that started in the early 1970s added fifty-four words that preserved a loophole for real estate and Wall Street investors that enabled them to put real estate in trusts to avoid taxes. The carried interest exemption and real estate trust provision are only two examples of tax loopholes initiated and maintained by lawyers and lobbyists for wealthy people.25
The rapid growth and high returns in finance raise questions about the role of finance in economic growth.

There were plenty—it’s just that almost all of them were either voted down or taken out and never even put up for a vote. Even something as simple and sensible as putting a cap on credit card interest rates. Senator Sheldon Whitehouse’s amendment to do just that was voted down 60 to 35.51 So much for “financial stability.” Though I suppose it depends on whose financial stability you care about—the banks’ or the taxpayers’.
Or how about payday lending—the largely unregulated advances on a paycheck that can carry interest rates in the triple digits? In Missouri, for example, rates can top 600 percent.52 Yes, you read that right. Not exactly a recipe for “financial stability.” North Carolina’s Kay Hagan offered an amendment that would have clamped down on the $40 billion industry. It was killed without a vote.53
Then there is the Merkley-Levin amendment that would have prohibited banks from making risky proprietary trades—a version of the Volcker Rule.54 It also never even made it to a vote.

…

Treasury.45 And they wouldn’t ban companies using offshore tax havens from receiving government contracts, which is stunning given the hard times we are in and the populist groundswell against the way average Americans are getting the short end of the stick.
But the bills would end one of the more egregious examples of the tax policy double standard, finally forcing hedge-fund managers to pay taxes at the same rate as everybody else. As the law stands now, their income is considered “carried interest,” and is accordingly taxed at the capital gains rate of 15 percent.46
According to former labor secretary Robert Reich, in 2009 “the 25 most successful hedge-fund managers earned a billion dollars each.”47 The top earner clocked in at $4 billion. Closing this outrageous loophole would bring in close to $20 billion in revenue—money desperately needed at a time when teachers and nurses and firemen are being laid off all around the country.48
But the two sets of rules—and the clout of corporate lobbyists—leave even commonsense, who-could-argue-with-that proposals in doubt, and leave the middle class shouldering an unfair share of a very taxing burden.

There are a lot of creative companies figuring out ways to follow the letter of the tax law while completely ignoring the spirit. This is how companies can make billions in profits yet pay little in taxes. And make no mistake, industries, professions, and groups of wealthy people deliberately manipulate the legislative system by lobbying Congress to get special tax exemptions to benefit themselves. One example is the carried-interest tax loophole: the taxation of private equity fund and hedge fund manager compensation at the 15% long-term capital gains tax rate rather than as regular income. Another is the investment tax credit, intended to help building contractors, that people used to subsidize expensive SUVs. There's also tax flight—companies moving profits out of the country to reduce taxes.
Estimates of lost federal revenue due to legal tax avoidance and tax flight are about $1 trillion.

Over the last decade, the political arm of the income defense industry has been wildly successful. The tax cuts passed by Bush and extended by Obama represent a total of $81.5 billion transferred from the state into the hands of the richest 1 percent. Meanwhile, hedge fund managers and their surrogates have deployed millions of dollars to lobbyists to maintain the so-called carried interest loophole, a provision of tax law that allows fund managers to classify much of their income drawn from investing gains as “carried interest” so that it is taxed at the low capital gains rate of 15 percent, rather than the marginal income rate, which would in most cases be more than twice that. It was this wrinkle in the law that helped Mitt Romney, a man worth an estimated quarter of a billion dollars, pay an effective tax rate of just under 14 percent in 2010.

Mitt Romney paid less than 14 percent on income in excess of $20 million, in both 2010 and 2011. That’s because so much of the income of the super-rich is classified as capital gains, which, at 15 percent, creates a loophole large enough for the super-rich to drive their Ferraris through. Well-heeled tax lawyers and accountants are kept busy year-round figuring out how to make the earnings of their clients look like capital gains. Congress still hasn’t closed the “carried interest” loophole that allows mutual-fund and private-equity managers to treat their incomes as capital gains.
Great wealth creates opportunities for ever greater tax loopholes. In 2010, eighteen thousand American households earning more than half a million dollars paid no income taxes at all. The estate tax (which affects only the top 2 percent) has also been slashed. As recently as 2000 it was 55 percent and kicked in after $1 million.

And through it all, hedge funds will remain the alternative investment that not only makes money, but perhaps more important, rationalizes the irrational market by flattening out the kinks in the global market.
In the Words of a Hedge Fund Legend . . .
Barton M. Biggs, Managing Partner, Traxis Partners
1. How would you define a hedge fund?
A hedge fund is a pool of money run by a small number of cocky, arrogant souls who charge outrageous fees including a carried interest and expect to shoot the lights out.
2. How or why did you get started in the industry?
I began running a fund for Alfred Jones and the first hedge fund A.W. Jones & Co. back in 1964 when I was an analyst at E.F. Hutton & Co.
3. What hedge fund strategies do you use?
I am a macro hedge fund manager and am inclined to concentrate on financial assets which I consider to be my circle of competence, in other words I don’t dabble in commodities and currencies.
4.

You wouldn’t think he’d have much to complain about. But, to hear him tell it, he’s beset by a meddlesome, tax-happy government and a whiny, envious populace. He recently grumbled that the U.S. middle class has taken to “blaming wealthy people” for its problems. Previously, he has said that it might be good to raise income taxes on the poor so they had “skin in the game,” and that proposals to repeal the carried-interest tax loophole—from which he personally benefits—were akin to the German invasion of Poland.19
Surowiecki went on to note that other wealthy executives have been voicing similar complaints. The venture capitalist Tom Perkins and the Home Depot cofounder Kenneth Langone, for example, each recently likened populist criticism of the wealthy to the Nazis’ attacks on the Jews.
Schwarzman and others have also been channeling vast sums to political action committees that lobby for still lower top tax rates and even less strict business regulation.

Most of these, I take to be self-evident – though incomplete. But whatever your remedies to the crisis of liberal democracy, nothing much is likely to happen unless the West’s elites understand the enormity of what they face. If only out of self-preservation, the rich need to emerge from their postmodern Versailles. At the moment they seem busier shoring up its fortifications. In 2009, the Obama administration proposed a modest taxation of carried interest that would have treated a small slice of capital earnings as income. This would have taken a tiny bite out of the incomes of the largest hedge-fund and private-equity tycoons. As Warren Buffet said, ‘It is not fair that I am paying lower taxes than my secretary.’ Wall Street rose up in opposition. ‘My administration is the only thing standing between you and the pitchforks,’ Obama told bankers in 2009.

It also makes sense to insist that firms receiving aid issue senior debt to the government with rights over all other bonds, etc., they have outstanding. That’s to make sure some money comes back right from the start and that managements cannot keep all the earnings for themselves by reducing accounting profits and paying themselves more.
To recapture some of the broader market gains flowing from the injection of public money, one could place a modest new tax on interest, dividends, capital gains. “Carried interest,” the ludicrous special tax break for private equity and hedge funds that not only Republicans but Senator Schumer and other Democratic Congressional leaders continue to defend, should go as part of any political deal on a bailout. It is beyond crazy to ask American workers to subsidize firms that will soon be back trying to break up their firms and throw their rescuers out of work.
And finally, obviously, it is necessary to re-regulate.

Credit card defaults leapt to record highs. The human suffering, which had been hidden from view behind numbers, spreadsheets, and risk scores, became palpable.
The chatter at Shaw was nervous. After the fall of Lehman Brothers in September of 2008, people discussed the political fallout. Barack Obama looked likely to win the election in November. Would he hammer the industry with new regulations? Raise taxes on carried interest? These people weren’t losing their houses or maxing out their credit cards just to stay afloat. But they found plenty to worry about, just the same. The only choice was to wait it out, let the lobbyists do their work, and see if we’d be allowed to continue as usual.
By 2009, it was clear that the lessons of the market collapse had brought no new direction to the world of finance and had instilled no new values.

Maybe what I’d thought was talent was simply being in the right place at the right time. Wall Street started to look less like a bunch of smartest-guys-in-the-room and more like a group of men who’d secured a seat in a ring of chairs surrounding a huge pile of money, a pile that was growing not because of their skill, but because that’s what money did. The system was structured—through monetary policy, carried interest deductions, corporate tax breaks, and industry lobbyists—to ensure it.
That might not sound like a crushing realization, but for me it was. I knew Wall Street wasn’t about doing something meaningful with your life, but I had seen it as a great coliseum for my young ambitions. Now it looked less like a meritocracy than an oligarchy.
People were referred to not by their accomplishments but by the size of their bank accounts.

This is not just about revisiting approaches and mindsets that result in excessive rigidity and austerity, and do so by chronically underestimating the size of the negative fiscal multipliers and the need for greater policy responsiveness—that is, the extent to which fiscal cuts unleash a dynamic that causes a disproportionately large reduction in overall aggregate demand. It is also about using tax and expenditure measures more actively to improve the quality of spending without unduly impacting the incentives that fuel innovation and entrepreneurship.
In the United States, for example, this would include—going from the least to the most controversial—closing tax loopholes and cascading exemptions, increasing the taxation of carried interest earned by private equity firms and hedge funds, reforming inheritance taxation, streamlining home mortgage subsidies, and a higher marginal tax rate for the highest-income earners. It would also involve decisive steps to modernize a system of corporate taxation that is littered with anomalies, distortions, and misaligned incentives that undermine rather than promote economic growth—including by encouraging firms to spend a lot of money on “inversions,” that is, the purchase of foreign entities in order to geographically shift and reduce tax burdens while keeping productive operations as is.

This favourable tax treatment leads high-income taxpayers to try to convert their earned income into capital gains. Those who have been most successful at this ploy are private equity, venture capital and hedge fund managers. Typically, the managers of these funds are paid an annual management fee of 2 per cent of the fund’s net assets, plus a 20 per cent performance fee based on the fund’s profits for the year. This performance fee, or ‘carried interest’ as it is sometimes called, can amount to millions of pounds. The managers of these funds have persuaded the government to allow them to classify this performance fee as a capital gain, even though it is simply income earned for a job performed and should be taxed as regular earned income.
The ostensible purpose of the lower capital gains rate is to compensate investors for the risk they take in investing their capital.

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The Wisdom of Finance: Discovering Humanity in the World of Risk and Return
by
Mihir Desai

The massive growth of the alternative assets industry over the last three decades is an underappreciated development in our capital markets. That development is predicated on the idea that some investors—such as hedge funds, private equity funds, and venture capital funds—are truly skilled and can generate alpha. That alpha generation serves as the foundation for their fees. Their fee structures—so-called carried interest—are a function of their performance, so, the logic goes, they only get paid when they do well.
Of course, the reality is not quite so benign. These investors have been shown to not outperform reasonable benchmarks on average, and the evidence of skill for most of them is fleeting—except for, perhaps, funds in the top decile of those funds. And their compensation is predicated on benchmarks that don’t usually reflect the risks they undertake.

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The Last Tycoons: The Secret History of Lazard Frères & Co.
by
William D. Cohan

When the US West Media Group bought Continental in 1997, the fund made nearly a $600 million profit. In total, over its initial twelve-year existence, Corporate Partners invested $1.35 billion in nine companies and received in return $2.99 billion, for a profit before fees and carried interest of $1.64 billion. Private-equity funds are judged on how well their investments perform over time, a calculation known as the internal rate of return, or IRR. Corporate Partners' IRR during its existence was 15 percent, net of fees and carried interest; investors received an annualized return of 15 percent per year. That placed its performance in the top quartile of such funds.
BILL CLINTON'S VICTORY in the 1992 presidential election handed Lazard another unexpected problem: a glum and cranky Felix Rohatyn. After twelve years of Republican Party rule, Felix rejoiced in the election of a Democrat to the White House.

…

Lazard invested $7 million in the new fund, to be called Providence Media Partners, along with Jonathan Nelson and Greg Barber, two partners of Narragansett Capital, who together invested $10 million. Steve also negotiated for himself and for Lazard one of the sweetest fee arrangements in capital-raising history. Since some of the Providence fund had been committed at the outset, Lazard was to raise only $175 million. For that work, the firm was to be paid a 1 percent placement fee, or $1.75 million, plus--and highly unusually--one-third of the General Partner's carried interest, or profits. Since the fund was enormously successful--returning to investors four times the amount of money invested--Steve figured the General Partner made $100 million, of which Lazard took around $33 million. But Steve had a side arrangement with Michel that gave him 8.25 percent of the firm's take, amounting to some $2.72 million for Steve alone, leaving the Lazard New York partners with around $30 million.

Ecuador: Quarterly Performance of the Main Components of the Current Account of the
Balance of Payments (US$ million), 1998.1–2001.4
US$ million
113
1,800
1,600
1,400
1,200
1,000
800
600
400
200
0
–200
–400
–600
–800
–1,000
–1,200
–1,400
–1,600
–1,800
Dollarization announcement
1
2
3
4
1998
1
2
3
4
1
2
1999
3
4
2000
Quarterly, 1998–2001
Oil exports
Other merchandise exports
Other current-account items
Source: Central Bank of Ecuador.
Merchandise imports
Interest due
1
2
3
2001
4
114
CRISIS AND DOLLARIZATION IN ECUADOR
new commercial-bank loans). Moreover, in November 2000 the banking
authorities eliminated a ceiling on fees that banks could change borrowers in lieu of interest, and removed a requirement that banks make provisions on loans carrying interest rates higher than 18 percent. In
December 2000 the government transferred US$137 million to the
Deposit Insurance Agency to enable it to make payments to insured
depositors. In January 2001 the Central Government on-lent funds from
the CAF to augment the resources of the bank liquidity fund, and made
the Central Bank’s liquidity recycling facility fully operational. These
changes persuaded the banks to increase lending in early 2001, contributing to the recovery.

The thinking here was that in the early eighties, with so many baby boomers now in their prime earning years, the Reagan administration would hike payments to build up a surplus that could in twenty or thirty years be used to pay out benefits when those same baby boomers reached retirement age. The administration accepted those proposals, and the Social Security tax rate went from 9.35 percent in 1981 to 15.3 percent by 1990.
Two things about this. One, Social Security taxes are very regressive, among other things because they only apply to wage income (if you’re a hedge fund manager or a Wall Street investor and you make all your money in carried interest or capital gains, you don’t pay) and they are also capped, at this writing at around $106,000, meaning that wages above a certain level are not taxed at all. That means that a married couple earning $100,000 total will pay roughly the same amount of Social Security taxes that Lloyd Blankfein or Bill Gates will (if not more, depending on how the latter two structure their compensation). So if you ignore the notion that Social Security taxes come back as benefits later on, and just think of them as a revenue source for the government, it’s a way for the state to take money from working- and middle-class taxpayers at a highly disproportional rate.

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The Corruption of Capitalism: Why Rentiers Thrive and Work Does Not Pay
by
Guy Standing

Mitt Romney, who ran for US President as the Republican candidate in 2012, paid a tax rate of only 14 per cent on his $22 million income in 2010, because most of it came from investments. The US advocacy group Citizens for Tax Justice has calculated that removing this subsidy to capital would raise $533 billion over a decade. Wealthy US hedge fund managers, four of whom paid themselves over $1 billion in 2015, also benefit from having their earnings treated as ‘carried interest’ and taxed at capital gains rates.
Another selective tax rate that privileges the rich is the low or zero inheritance tax in many countries. US inheritance tax only kicks in on estates over $5 million. In the UK, the government has raised the threshold for such tax to £1 million for wealthy, home-owning couples (and there are ways of minimising the tax through trusts and the like). In Australia and New Zealand, there is no inheritance tax at all, while in many European countries the tax is minimal for family members.

Treasuries can be bought at auction directly from the government without a fee, allowing you to manufacture your own “Treasury Fund” at no expense. (You can reach Treasury Direct at 1-800-722-2678 and www.publicdebt.treas.gov/sec/sectrdir.htm.) Even if you are purchasing a Treasury at auction through a brokerage firm, the fee is nominal—typically about $25. For a five-year note worth $10,000, this equals an annual expense of 0.05%.
• High-quality corporate bonds and commercial paper. Corporates not only carry interest rate risk, but also credit risk. Even the highest-rated companies occasionally default. How often does this happen? Very rarely. According to bond-rating service Moody’s, since 1920 the rate of default for the highest-rated AAA bonds was zero, 0.04% per year for AA-rated, 0.09% for A-rated, and 0.25% for BBB-rated. BBB is the lowest of the four “investment-grade” categories.
These categories are a tad deceptive, since, for example, it is highly unlikely that an AAA-rated bond would suddenly default—it would likely undergo successive downgradings first.

People working within this system can thus believe—and do believe—that they’re doing nothing wrong by going along with how things work.
Sometimes this going-along produces benefits that seem venally corrupt. Because of a loophole in the tax system (one that has existed since the 1960s), managers of hedge funds don’t pay ordinary income tax on the money they earn from hedge funds. Instead, their “carried interest” gets taxed at 15 percent.32 Thus, though the top ten hedge fund managers in 2009 made, on average, $1.87 billion, they paid a lower tax rate on that income than their secretaries.33 Obama promised to change this. But that change was blocked. Its very hard not to understand the very richest in our society enjoying the same tax rate as individuals earning between $8,000 and $34,000 as anything other than a kind of venal corruption.

Income that you earn by actually doing a job is taxed at a much higher rate than income you earn from your investments.
Warren Buffett famously took on this issue in 2011 in a New York Times piece, noting that while the taxes he paid the previous year amounted to 17.4 percent of his income—or $6,938,744 total—the tax burden on other people in his office averaged 36 percent.32 (For his assistant Debbie Bosanek it was 35.8 percent.)33 That’s because Buffett makes money from things like “carried interest” on investments, capital gains from selling stocks, and so on. Like most billionaires and many millionaires, he declares very little “earned” income but a lot of asset wealth gains. As Buffett says, “these and other blessings are showered upon us [meaning, the rich] much as if we were spotted owls or some other endangered species. It’s nice to have friends in high places.”34
Most of us, however, make money from the pay we get working day jobs, which is taxed at a far higher rate (most middle-class people fall into a 15–25 percent income tax bracket and then pay high payroll taxes to boot).

CHAPTER 30
Garrett Hardin Hardin, Garrett, “The Tragedy of the Commons,” Science, Vol. 162, No. 3859 December 13, 1968, pp. 1243–48.
protects my neighbors Vaccination is a positive externality as it protects others from contracting a disease from the recipient.
collection of insights Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger, Foreward by Warren Buffett, edited by Peter Kaufman. Expanded third edition, 2008.
much of their income Read the evolving discussion of the taxation of so-called carried interest in Wikipedia and elsewhere on the Internet. The 2012 Republican presidential candidate, Mitt Romney, was a substantial beneficiary.
of national income The top 1 percent have about a third of taxable income, the next 9 percent have another third, and the bottom 90 percent have the remaining third.
20 percent or so To get a simplistic feel for the numbers, government received $3.25 trillion in income in 2015 and GNP was $18 trillion.

He argued that the fact that Deuteronomy allows usury under any circumstances demonstrates that this could not have been a universal “spiritual law,” but was a political law created for the specific ancient Israeli situation, and therefore, that it could be considered irrelevant in different ones.
29. And in fact, this is what “capital” originally meant. The term itself goes back to Latin capitale, which meant “funds, stock of merchandise, sum of money, or money carrying interest” (Braudel 1992:232). It appears in English in the mid–sixteenth century largely as a term borrowed from Italian bookkeeping techniques (Cannan 1921, Richard 1926) for what remained when one squared property, credits, and debts; though until the nineteenth century, English sources generally preferred the word “stock”—in part, one suspects, because “capital” was so closely associated with usury.
30.

Managers used privileged access to information about a company’s activities to lower the price, paving the way for a LBO that might benefit them. Where they were part of the LBO, existing management claimed to know how to fix or improve the business—but only if given a large equity interest. It was legal blackmail.
Buyout firms collected a fee, typically 1 percent of each purchase. In addition, the buyout firm charged an annual management fee, around 1–2 percent, on the investors’ funds, managed plus 20 percent carried interest, receiving a share of any investment gains on disposition. They charged annual monitoring and director’s fees. During negotiations, Gerald Saltarelli, chairman of Houdaille, argued that KKR should not be entitled to any fee for buying the company. Kohlberg argued he was entitled to a fee: “I’m an investment banker.”17
Lenders got high interest rates as well as substantial fees. When junk bonds started to be used for financing LBOs, Drexel Burnham Lambert (Drexel) received a fixed fee (0.50–1 percent) of the amount raised, a commitment fee, an underwriting fee, an advisory fee, warrants over the stock, and expenses.

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What Went Wrong: How the 1% Hijacked the American Middle Class . . . And What Other Countries Got Right
by
George R. Tyler

The ATO is demanding that the Luxembourg and Cayman Island shell companies pay taxes, interest, and penalties due Australia.76 The lesson for the United States is this: The ATO’s Texas Pacific tax bill presumes logically that the proceeds of the Myer transaction be taxed as ordinary income, rather than as capital gains, as lobbied by Texas Pacific. In December 2010, the ATO determined that since buying and selling firms is the main activity of enterprises such as Texas Pacific, proceeds on such transactions are taxable as ordinary business income, not as capital gains.77 This is the same logic involved in the carried-interest debate in the US Congress, where reform is presently gridlocked by Congressional Republicans.
Restore Financial Market Discipline by Eliminating Red Queens
The American economy needs to be protected from the baker’s dozen Red Queens that have emerged in recent decades of willful neglect of antitrust laws. The goal of that protection was spelled out by Walter Bagehot a century and a half ago:
“The business of banking ought to be simple.

By the way, the previous approach to accounting for stock options was even odder: options granted with a strike price equal to the market price had no expense impact, but those granted below market would, in some cases, result in an expense every year thereafter that the underlying stock rose. There is equal confusion to be found in the FASB approach to accounting for derivatives, hedging, pensions, leases, and recognition of profits for carried interests, to name a few. Now companies can even record a profit if their debt gets downgraded. Sometimes accounting rules seem designed to carry us very far from economic reality, and some managers are quite amenable to taking investors on such a journey.
Having analyzed the historical record, the second and far greater challenge is to determine “the utility of this past record as an indication of future earnings.”